A seven-point checklist to make money in MFs

With the stock markets in a treacherous arena these pointers will help you keep your head above the water.

Investing in sector funds seems deceptively easy, but history has shown that investors usually make a mess of things. Most sector fund investors have lousy timing, and their choice of funds isn't all that great, either.

On the one hand you have investors who read about all the good things going on in an industry. They see business is booming and long-term macro trends are supporting that growth so that it looks like the trend could last a long time.

At about the same time, stocks and funds focused on that industry are putting up big returns.

This triggers envy because investors wish they had been there and greed because they figure they can get rich, too, by hopping on the bandwagon. In fact, the longer a trend goes on, the greater the inflow of money into a sectoral fund.

The catch is that Dalal Street is aware of all that good news and has already priced it into the prices of the stocks. In fact, Dalal Street probably learned about it before you did. Fund companies know this, too, but they also know that they can make a fast buck by selling new or already existing sector funds to greedy investors.

So, the fund companies where employees are most focused on quick profitability typically roll out trendy sector funds. Generally, the more responsible fund companies will refrain from doing this because they know that there's a good chance the fund will do terribly and shareholders will be steamed.

How to make sector funds work for you

Now that we have spelled out what can go wrong, let’s discuss how you can make things go right. There are good reasons to buy a sector fund, such as plugging a hole in your portfolio or hiring a brilliant industry specialist, and you can do just fine with them, but you have to be smarter than the lemmings I've described above.

Courtesy:

1. Don't invest with the headlines

If your local newspaper has an article about a great trend and the folks who made a killing in it, it's probably too late. You can see this in a sector fund's returns, too. If it has crushed the S&P CNX Nifty for two or three years running, you're too late.

2. Be patient

If you're looking out 10 years instead of 12 months, you stand a much better chance of enjoying a good return.

3. Be early

This is a corollary to the two rules above. Look for a sector that has been out of favour for some time and you stand a better chance of finding something ready to run.

4. Look for a manager with expertise in the sector

The main value in choosing a sector fund is that you can sometimes get a specialist who knows the sector better than the average diversified fund manager. Therefore, you should look for a manager with a long track record in the sector and ideally a firm with that history.

Most sector funds are run by third-tier managers. You need to find the exception. You want funds where the managers are true experts who see running a sector fund as their career goal rather than a stepping stone.

5. Don't forget about costs

Short-term thinking and greed lead investors to ignore expenses in sector funds, yet they're just as important here as in an index fund. Many of the best sector funds charge reasonable expenses. So, rather than settle for some poor-quality fund with a high expense ratio, shop around.

6. Keep tabs on your reasons for buying a fund

If the reasons you bought the fund (a great manager or a long-term trend) are no longer valid, you should get out. For example, a few years ago many people thought the power/infrastructure sector was going to enjoy a long and glorious boom. It turns out that was a bubble. So, at some point, investors had to accept that their thesis was wrong. If your reasoning was wrong or the great manager you liked has left, you should consider moving on.

7. Don't make them your core

Sector funds can fill a gap or serve as a speculative play, but you should have diversified funds at the core of your portfolio. If you have a portfolio of sector funds you're likely to have left some key gaps and you'll probably be paying more in expenses than you should.